All Eyes on Chengdu

This weekend the G20 Finance Ministers and Central Bank Governors meet in Chengdu. It is a number of years since I visited Chengdu but I can testify that it is a great location in which to host such an important meeting. The leaders will be able to see at first hand a transformed modern Chinese city. It should also be a reminder - if they needed it - of how far China has come and that, despite the current caution about the world economy, it would be premature to be too pessimistic about what lies ahead.

One of the key topics for the G20 will likely be the outcome of the UK referendum. Yet, four weeks after the result, it is already clear that the global contagion from the vote to leave has been limited. This has not been a repeat of the financial crisis as some feared. Although there was an initial market impact and has been some volatility since, the reassuring feature for many has been how resilient financial markets have proved. The G20 should be relieved by that.

Of course, sterling has weakened significantly since the referendum. That in itself is no bad thing, as the pound had appeared overvalued for some time, as the large current account deficit might suggest. It has also acted as an important shock absorber for the UK. But it leads into a key global issue, namely the role of currency moves in overall policy. The Americans, in particular, are keen to prevent others from deliberately seeking a weaker currency as a way to boost economic performance. In recent years the dollar has been particularly strong. That in itself has been one of many factors deterring the Fed from hiking too much, but it has also weighed slightly on the US recovery. The last thing the US currently wants is for the dollar to strengthen even further. Hence they will be keen to ensure that neither Japan or China will be tempted via policy to weaken their currencies. Currently there is still pressure, particularly in Japan, to use a weaker currency to boost growth. In addition, both will seek to boost their economies through other domestic means.

The mood at the G20 should be more positive than at recent meetings. In addition to the financial system proving itself resilient in the aftermath of the Brexit vote, the world economy has not been hit by any renewed setbacks in the first half of the year. Despite this, the mood is still cautious among policy makers and markets. This was highlighted over the last week by the latest update from the International Monetary Fund (IMF) on its economic thinking. As has been the case in recent years the IMF reduced its forecasts for global growth. This time it cut by 0.1% to 3.1% for this year and down by a similar margin to 3.4% for next. The IMF still finds it hard to give a positive message, as highlighted by its description of the advanced economies as being lacklustre, with low potential growth and only a gradual closing of output gaps. They could equally have said growth was stabilising with inflation low.

The biggest problem for the western economies is still a lack of demand. Perhaps with that in mind, we may see the G20 talk more about the need to use overall economic policy to boost global growth. Monetary policy has already had an impact. Interest rates are low, longer term borrowing rates are negative in many countries and central bank balance sheets have grown considerably through quantitative easing. Now more countries are looking to use fiscal and supply side policies too.

The IMF cut is forecast for UK growth as a result of the Brexit vote. After 3.1% growth last year and 2.2% this, the IMF sees the UK growing 1.7% this and 1.3% next. Despite this, the IMF still sees the UK growing faster than Germany, France and Italy in both years. It is of course, too early to tell what the impact of the Referendum will be. The biggest danger would appear to be the UK talks itself into a self fulfilling downturn. But the ending of political instability with the new Prime Minister and Cabinet in place weeks earlier than expected has been a big positive. Now, there is the need for clarity on policy both in terms of the domestic economy and with regards to the EU.

There is a strong case for a relaxation of fiscal policy. The new Chancellor may be reluctant to spook the financial markets too much, as he is likely to still want to give a tough message on the need to reduce the deficit. But even allowing for that, there should be scope for more flexibility on tax cuts. It would also be strange if the UK were to not take advantage of incredibly low government borrowing rates, to borrow longer term to fund more infrastructure spending. Indeed, the low level of borrowing rates for many western economies is perhaps the most significant policy opportunity of the year. It can have a profound effect on providing countries with more room for fiscal manoeuvre as well as on lowering the cost of capital for many corporates too. It should also encourage investors into riskier investments.

The Bank of England, having left rates unchanged at its recent meeting, has kept open the option to do more to stimulate the economy if it needs to. It may feel it does not. But for now, interest rates look set to remain low for some time, and may yet be cut further.

In this environment, investors should take comfort from the resilience of financial markets in the wake of the Brexit vote and be reassured by the effectiveness of policy with rates staying low and fiscal policy being used more effectively. Naturally there may be some concern about future Brexit negotiations but I take a positive view about what lies ahead and will write about this in coming weeks. Meanwhile, one of the interesting issues for investors will be the extent to which global growth is able to demonstrate increased resilience in the months ahead.

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